• Standard for Defalcation Exception to Discharge to be Decided By U.S. Supreme Court
  • February 14, 2013 | Authors: Elizabeth J. Austin; Irve J. Goldman; Jessica Grossarth; H. William Shure
  • Law Firms: Pullman & Comley, LLC - Stamford Office ; Pullman & Comley, LLC - Bridgeport Office
  • In March of this year, the United States Supreme Court will hear argument on the appropriate standard to apply in determining whether a debtor has engaged in a “defalcation” while acting in a fiduciary capacity. Bullock v. Bank Champaign NA (In re Bullock), U.S. 11-1518. Under section 523(a)(4) of the Bankruptcy Code, debts arising from “fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny” are not dischargeable in bankruptcy.

    In Bullock, the debtor, while acting as a trustee of his father’s trust, and contrary to its express limitations, borrowed substantial sums from the trust for his mother to use to repay a debt owed to the father’s business and for the debtor and his mother to make personal and business investments. All of the loans were paid back with interest. The debtor’s siblings, who were beneficiaries of the trust along with the debtor, brought suit against the debtor in Illinois state court for breach of fiduciary duty based on the debtor’s self-dealing. The state court determined that the debtor was liable for damages in the amount of $250,000, which it measured based on the amount of the benefit the debtor received from the self-dealing, and imposed a constructive trust on the property obtained with the borrowed funds. The court appointed a bank as trustee of the constructive trust.

    After the bank blocked the debtor’s attempt to sell the property to pay off the judgment debt, the debtor filed a Chapter 7 bankruptcy with the objective of having it sold in bankruptcy. The bank filed an action to determine the $250,000 judgment debt non-dischargeable based on what it claimed was the debtor’s defalcation based on self-dealing. Summary judgment was granted to the bank without any evidence of the debtor’s mental state in borrowing the funds, on the basis that his self-dealing was objectively reckless and thereby satisfied the standard for a “defalcation.” The Eleventh Circuit affirmed.

    Certiorari was granted to resolve a split among the circuits on the level of culpability a debtor must have to engage in a “defalcation.” In the First and Second Circuit, a “defalcation” under §523(a)(4) can only occur if there is “extreme recklessness.” In re Hyman, 502 F. 3d 61 (2d Cir. 2007); In re Baylis, 313 F. 3d 9 (1st Cir. 2002). The “objectively reckless” standard was applied in the Bullock case by the Eleventh Circuit and was previously adapted by the Fifth, Sixth and Seventh Circuits. An even lesser standard, mere negligence or a failure to account for entrusted property, has been applied by the Fourth, Eighth and Ninth Circuits.